Tax Reform Alters ESOP Landscape

EXECUTIVE SUMMARY

PROVISIONS IN THE ECONOMIC GROWTH AND TAX RELIEF Reconciliation Act of 2001 raised ESOP contribution limits and liberalized companies’ combined use of ESOPs and 401(k) plans. The new law raises the contribution limits that can be added annually to an individual employee’s account—from both employer contributions to ESOPs and other defined plans. It also raises the maximum amount an individual can defer into a 401(k) plan to $11,000 from $10,500. EMPLOYEES’ ELECTIVE DEFERRALS INTO their 401(k) plans will no longer reduce the tax-deductible limit on the amount the employer can contribute to a defined contribution plan (ESOP) or combination of plans. CPAs should explain the wide-ranging implications of these changes to their clients so they can incorporate them into their benefit plans and take full advantage of these provisions. NEW PROVISIONS IN THE TAX LAW address some S corporations’ abuse of ESOP tax benefits by closing previously existing loopholes. The law requires plan managers to perform a two-step process to determine whether the S corporation and the ESOP participant will be subject to punitive tax treatment by identifying “disqualified” persons and determining whether the disqualified individuals own at least 50% of all shares. C CORPORATIONS ARE NOW ALLOWED to deduct dividends paid on allocated and unallocated shares that employees voluntarily reinvest in company stock in the ESOP. Dividends that are reinvested by the employee into company stock are taxable to the employee. But the company can create a dividend “switchback” program that will provide the equivalent of a pretax dividend..

BRYAN GIRARD is director of communications for the National Center for Employee Ownership in Oakland, California. His e-mail address is bgirard@nceo.org .

lthough employee stock ownership plans have existed for more than 25 years as an employee benefit and a retirement tool, their legal structure continues to evolve. With the Economic Growth and Tax Relief Reconciliation Act of 2001, Congress enacted significant changes, effective in 2002, to employee benefit plans which raised the total dollar amount of contribution limits and liberalized companies’ combined use of ESOPs and 401(k) plans (for more information on the tax bill, see “ Making Sense of the New Tax Legislation ,” JofA , Sep.01, page 22). This article discusses how the legislation has affected ESOP use and recommends CPAs and plan sponsors review the changes with their corporate and small business clients so they can realize tax benefits associated with the new rules..

These revisions provide a solution for companies that in the past sometimes found they had to terminate their 401(k) plans after creating an ESOP program because their ESOP contributions already were approaching the limits. “Telling employees they could no longer have a 401(k) plan could be a significant disadvantage for companies,” says Dennis Long, president of Appleton, Wisconsin-based BCI Group, the country’s largest ESOP/401(k) administration company. Formerly, companies contributing the maximum to an ESOP (25% of each employee’s pay per year) were precluded from having a 401(k) plan; companies that neared the maximum were confined to 401(k) plans with limited funding. The tax law of 2001 virtually eliminates this problem.

Two kinds of contribution limits now affect businesses. The first, IRC section 404, governs how much a company can deduct from its taxes for its contributions to a retirement plan; the second, IRC section 415, stipulates how much employers and employees can add to individual employee accounts. Employees’ elective deferrals to their 401(k) plans will no longer reduce the tax-deductible limit on the amount the employer can contribute to a defined contribution plan (ESOP) or combination of plans. CPAs should explain the wide-ranging implications of these changes to their clients so they can incorporate them into their benefit plans and take full advantage of these provisions.

Under prior law if a company did not borrow money through an ESOP (or if the company was an S corporation ESOP), the maximum annual contribution limit to the ESOP was 15% of total eligible pay. The new limit is 25% of pay for all ESOP plans. Moreover, companies can take a tax deduction for “reasonable” dividends—which the IRS defines as those “that are justified by earnings and in line with standard industry practice”—paid on ESOP shares that employees voluntarily reinvest in the plan to buy more company stock (for an example of how the changes work, see exhibit 2, below).

SCRUTINY OF S CORPORATIONS

By closing previously existing loopholes, the legislation also addresses some S corporations’ abuse of ESOP tax benefits. New provisions essentially prevent very small companies controlled by only a handful of people from setting up ESOPs primarily for their own financial gain. The law requires plan managers to perform a two-step process to determine whether the S corporation and the ESOP participants will be subject to punitive tax treatment:

Identify “disqualified persons.” Under the law a “disqualified person” is an individual who owns 10% or more of the allocated and unallocated shares in the ESOP or who, together with family members (spouses or other family members, including lineal ancestors or descendants, siblings and their children or the spouses of any of these other family members), owns 20% or more of such shares. Synthetic equity, broadly defined to include stock options, stock appreciation rights and other equity equivalents, is also counted as ownership for this purpose.

Determine whether disqualified individuals own at least 50% of all shares. In order for plan managers to calculate the total number of shares disqualified individuals own, they must count shares held directly, shares owned through synthetic equity and allocated or unallocated shares owned through the ESOP.

If disqualified individuals own at least 50% of the company’s stock and receive an allocation from the ESOP during the current year, they will incur a substantial tax penalty. An allocation occurs when ESOP shares are added to a participant’s account; the allocation will be taxed as a distribution to the recipient, and a 50% corporate excise tax will apply to the fair market value of the stock allocated. If the recipient owns synthetic equity, an additional 50% excise tax will apply to its value. In the first year this rule applies, there will be a 50% tax on the fair market value of shares allocated to disqualified individuals even if no additional allocations are made to those individuals during that year. Thus, the tax applies if disqualified individuals own more than 50% of the company in the first year.

DIVIDEND TREATMENT FOR C CORPORATIONS

Certain ESOP incentives available to C corporations are not available to S corporations. For example, unlike S corporations, C corporations are allowed to have a different class of stock and are able to deduct dividends. The new law allows C corporations to deduct dividends paid on allocated and unallocated shares that employees voluntarily reinvest in company stock in the ESOP. Under prior law C corporations could deduct dividends they paid on allocated or unallocated ESOP shares to repay an ESOP loan. C corporations also were able to deduct dividends passed directly through to employees. Dividends an employee reinvests into company stock are still taxable to the employee but the company can create a dividend “switchback” program that will provide the equivalent of a pretax dividend to the employee.

The new law allows for a simple procedure under which both the employer and the employee can avoid tax on the dividend. “The C corporation can now deduct the dividend if the employee reinvests it as employer stock directly in the ESOP,” says Nancy K. Dittmer, CPA, of RSM McGladrey Inc. in Des Moines, Iowa. “There is no need for the dividend switchback program unless the employee wants to reinvest on a pretax basis in the 401(k) for investment diversification purposes.” Dittmer notes that if the employee decides to reinvest the dividend as employer stock into the ESOP, the reinvestment does not apply toward the employee’s 401(k) deferral limit ($11,000) or other contribution limitations. To create a deductible dividend under the old law, companies had to obtain letter rulings from the IRS for dividend switchback arrangements. (Recent IRS rulings have made it clear, however, that S corporation ESOPs can use dividends paid only for unallocated shares as repayment for an ESOP loan and even then such dividends are not deductible.)

The new approach may be of particular interest to public companies because they are allowed to deduct the dividend. For private companies it could mean considerable expense to comply with regulations the SEC imposed. For example, a private company could spend $10,000 to $25,000 to file for an exemption to the dividend laws and to file an antifraud disclosure statement, with no guarantee of obtaining the exemption. If the company does not receive an exemption and then wishes to register its shares for public trading, it faces significant initial and ongoing expenses related to registration, administration and reporting.

WATCH WHAT CONGRESS DOES An ESOP is a flexible financial vehicle for corporate growth, and like other tax-qualified retirement plans, it must comply with participation, benefit allocation and distribution rules (exhibit 3, at right, lists some of the available plan resources). As a result of the publicity surrounding Enron because its employees lost retirement savings, proposals to address the vulnerabilities in defined contribution retirement plans have appeared from Congress, regulators and employee/investor associations. President George W. Bush proposed his own series of legislative controls and a number of other plans are on the table. As of this writing none of the proposed bills would affect private-company ESOPs in any way (by requiring earlier diversification in ESOPs). Public company ESOPs integrated with 401(k) plans, however, could be subject to new rules on diversification rights and other issues. The new tax law makes ESOPs more attractive and makes it much easier for companies to combine ESOPs with 401(k) plans. Despite a recession and negative perceptions of employer stock in pension plans brought about by the collapse of Enron, these plans are here to stay—private company ESOPs continue to emerge and public companies are standing behind their ESOPs and 401(k) plans. CPAs need to be familiar with the reforms and their timing to maximize the new plan features for their clients.

Exhibit3: ESOP Resources Buck Consultants, www.buckconsultants.com . International employee benefits consultants with headquarters in New York City. The ESOP Association of America, www.esopassociation.org . A trade association that lobbies for ESOP companies and tracks legislation. The Foundation for Enterprise Development, www.fed.org . The foundation focuses on entrepreneurial employee ownership with a particular emphasis on technology businesses. The Global Equity Organization, www.globalequity.org . GEO is a worldwide membership organization of companies and consultants dealing with international and multinational equity compensation concerns. The National Center for Employee Ownership, www.nceo.org . The NCEO is a nonprofit membership and research organization offering a newsletter, legal journal, publications, conferences and seminars on broad-based employee stock ownership plans.